Take The Easy Money And Run

Cheaper Foreign Oil Caps US Drilling Outlook

The shale oil revolutionaries are retreating in disarray, and cheap foreign oil may banish them to the margins of the market.

As oil and natural gas move into a period of low prices, new data shows that North American drillers may not have the wherewithal to keep producing shale wells, which make up 90 percent of new drilling. In fact, if prices remain low for years to come, which is a real possibility, then investors may never see a return on the money spent to drill shale wells in the first place.

The full cost of producing oil and natural gas at a representative sample of U.S. companies, including capital spent to build the company and buy assets, is about $80 per barrel of oil equivalent, according to a study from the Bureau of Economic Geology’s Center for Energy Economics at the University of Texas.

The analysis of 2014 corporate financial data from 15 of the top publicly traded producers, which I got an exclusive look at before it’s published this week, determined that companies will have a hard time recovering the capital spent that year and maintaining production unless prices rise above $80 a barrel.

The price for West Texas Intermediate has spent most of the year below $50 a barrel.

Low prices, though, won’t mean that producers will shut in existing wells. Many of these same companies can keep pumping to keep cash coming into the company, and they can still collect a 10 percent return above the well’s operating costs at $50 a barrel of oil. They just won’t make enough money to invest in new wells or recover the capital already spent.

This harsh reality of what it will take to keep the shale revolution going shows how vulnerable it is to competition from cheap overseas oil.

“Everyone walks around thinking that they know how much this stuff costs because they see published information on what people spend to just drill wells,” explained Michelle Foss, who leads the Houston-based research center. “That is not what it takes for a company to build these businesses, to recover your capital and to make money.” The bureau was founded in 1909 and functions as the state geological agency.

Low oil prices will also exacerbate the economic impact of low natural gas prices. For years natural gas has kept flowing despite prices below $4 for a million British thermal units because about 50 percent of wells produced both gas and liquids, such as crude oil and condensate.

True natural gas costs

High oil prices have helped companies subsidize natural gas wells, but lower oil prices mean natural gas wells that don’t produce liquids will need to stand on their own economics.

The center’s analysis found that among the sample companies focused primarily on gas, prices will need to top $6 a million BTUs just to cover full costs and rise above $12 a million BTUs to recover the capital expended to develop the wells.

“We have important resources, but people have to be realistic about the challenges of developing them,” Foss told me. “There will have to be higher prices.”

Everyone predicts prices will rise again. The only questions are how quickly and to what price. Some experts predict WTI prices will reach $70 a barrel by the end of 2015, while others see $60. The soonest most expect to see $80 a barrel oil is in 2017. Saudi Arabian officials have said they believe the price has stabilized and don’t see oil returning to $100 a barrel for the next five years.

High prices and shale

The Saudi opinion is particularly important because that nation can produce oil cheaper than any other country and can produce more oil than any other country. As the informal leader of the Organization of the Petroleum Exporting Countries, Saudi Arabia kept the price of oil inside a band between $80 and $100 a barrel for years. Now, the Saudis appear ready to keep the price low.

That’s because high prices inspired the shale revolution, where American companies figured out how to economically drill horizontally into tight rocks and then hydraulically fracture them to release oil and natural gas. Since OPEC countries rely on high oil prices to finance their governments, everyone assumed OPEC would cut production and keep revenues high.

Arab leaders, though, were more concerned about holding on to market share and allowed prices to fall below levels that make most shale wells economic. Foss, who recently returned from meetings in the United Arab Emirates, said OPEC is unlikely to change course because developing countries are seeking alternatives to oil and reducing demand.

“The Saudis and their partners see pressures on oil use everywhere they look, and what they want is their production, in particular their share of the global supply pie, to be as competitive as it can be to ensure they’ve got revenue coming into the kingdom for future generations,” she said.

OPEC is afraid rich countries like the U.S. are losing their addiction to oil, and by lowering prices hope to keep us hooked. And OPEC has plenty of product.

“There’s 9 million barrels a day in current and potential production capacity in Iraq and Iran that is tied up by political conflicts, and if you sort that out enough, that’s a flood of cheap oil onto the market,” Foss said.

On the losing end

If prices remain low, the big losers will be the bond holders and shareholders of indebted, small and medium-size companies that drill primarily in North America. Since these companies are not getting high enough prices to pay off capital expenditures through higher share prices or interest payments , they are in serious trouble.

The inability of Denver-based Whiting Petroleum to sell itself is an example. The board of the North Dakota-focused company was forced to issue new shares, reducing the company’s value by 20 percent, and take on more expensive debt. Quicksilver Resources, based in Fort Worth, filed for Chapter 11 bankruptcy on March 17 because it couldn’t make the interest payments on its debt and no one was willing to invest more capital.

Until one of these companies is bought, we won’t know the true value of the shale producers at the current oil and natural gas prices.

But as more data reaches the market, there is a real danger that these companies are worth even less than investors fear, even though they may have high-quality assets.

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